Thursday, June 13, 2013

A Foolproof Approach to Monetary Policy For Both Fiscalists and Monetarists

Cardiff Garcia says we all need to get along. At least the fiscalists and market monetarists who believe there is still a aggregate demand shortfall. He makes the case that both sides should tolerate and even embrace each other. Here is Garcia on market monetarists:

But there is one sense in which even the monetarist position is amenable to fiscal stimulus, and it is this. A belief of the market monetarists is that if NGDP level targeting were properly embraced, then the awful outcomes characteristic of a Great Recession — a slowdown of NGDP growth, calamitous falls in asset prices, the disintegration of usable collateral — would be avoided in the first place...

As such, the very impetus for using fiscal policy to stabilise the economy and accelerate the recovery would be unnecessary...The monetarists therefore wouldn’t be inconsistent if they were to say: Sure, keep fiscal stabilisation policy at the ready in case we fail. We just don’t think it will be necessary. If it does turn out to be necessary, well, go for it.

Okay, but not all fiscal policy is equal. Fiscal policy geared toward large government spending programs is likely to be rife with corruption, inefficient government planning, future distortionary taxes, and a ratcheting up of government intervention in the economy. So I will pass on this type of fiscal policy. Fiscal policy, however, that largely avoids these problems and directly addresses the real issue behind the aggregated demand shortfall--an excess demand for safe, money-like assets--I will endorse. And that form of fiscal policy is a helicopter drop, a government program that gives money directly to households. The Fed would finance it and the Treasury Department would deliver it to each household. This idea is not new. It was originally suggested by Milton Friedman and recently discussed by the conservative AEI. So it should have appeal across both parties.

Here is how I would operationalize this policy. First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap. In other words, if the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits.

Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.

This two-tier approach to NGDP level targeting should create a foolproof way to avoid liquidity traps. It should also reduce asset boom-bust cycles since NGDP targets avoid destablizingresponses to supply shocks that often fuel swings in asset prices. This approach is consistent with Milton Friedman's vision of monetary policy, would impose a monetary policy rule, and provide a solid long-run nominal anchor. Finally, per Cardiff Garcia's request it would satisfy both fiscalists and monetarists. What is there not to like about it?

P.S. I would be glad to submit this proposal to Representative Kevin Brady for consideration in his centennial commission on monetary policy. It would be great to see Congress discuss reforming the Fed along these lines.

"Milton Friedman, who died last week at 94, was the patron saint of small-government conservatism. Conservatives who invoke his name in defense of Social Security privatization and other cutbacks in the social safety net might thus be surprised to learn that he was also the architect of the most successful social welfare program of all time.

Market forces can accomplish wonderful things, he realized, but they cannot ensure a distribution of income that enables all citizens to meet basic economic needs. His proposal, which he called the negative income tax, was to replace the multiplicity of existing welfare programs with a single cash transfer — say, $6,000 — to every citizen. A family of four with no market income would thus receive an annual payment from the I.R.S. of $24,000. For each dollar the family then earned, this payment would be reduced by some fraction — perhaps 50 percent. A family of four earning $12,000 a year, for example, would receive a net supplement of $18,000 (the initial $24,000 less the $6,000 tax on its earnings).

Mr. Friedman’s proposal was undoubtedly motivated in part by his concern for the welfare of the least fortunate. But he was above all a pragmatist, and he emphasized the superiority of the negative income tax over conventional welfare programs on purely practical grounds. If the main problem of the poor is that they have too little money, he reasoned, the simplest and cheapest solution is to give them some more. He saw no advantage in hiring armies of bureaucrats to dispense food stamps, energy stamps, day care stamps and rent subsidies.

As always, Mr. Friedman’s policy prescriptions were shaped by his desire to minimize adverse economic incentives, a feature that architects of earlier welfare programs had largely ignored. Those programs, each administered by a separate bureaucracy, typically reduced a family’s benefits by some fraction of each increment in earned income. Rates of 50 percent were common, so a family participating in four separate programs might see its total benefits fall by $2 for each extra dollar it earned. Under the circumstances, no formal training in economics was necessary to see that working didn’t pay. In contrast, someone who worked additional hours under Mr. Friedman’s plan would always take home additional after-tax income.

The negative income tax was never adopted in the end, because of concern that a payment large enough to support an urban family of four might induce many to go on the dole. With a payment of $6,000 per person, for example, rural communes of 30 would have a pooled annual payment of $180,000, which they could supplement by growing vegetables and raising animals. Because these groups could live quite comfortably at taxpayer expense, there would be an eager audience for accounts of their doings on the nightly news. Political support for such a program would be difficult to sustain.

Instead, Congress adopted the earned-income tax credit, essentially the same program except that only people who were employed received benefits. One of the few American welfare programs widely adopted in other countries, the earned-income tax credit has proved far more efficient than conventional programs, just as Mr. Friedman predicted. Yet because it covers only those who work, it cannot be the sole weapon in society’s antipoverty arsenal..."

http://www.nytimes.com/2006/11/23/business/23scene.html

P.S. Friedman also coined the parable in which price deflation is fought by "dropping money out of a helicopter" to people in "The Optimum Quantity of Money".

Pages 4-5:“Let us suppose now that one day a helicopter flies over this community and drops an additional $1000 in bills from the sky,...”

I suggest that Friedman did support “government giving money to households in the way that garcia pointed out.” In a paper in 1948 p.250-1, he advocates that in a recession, government should run a deficit funded by freshly printed money. Whether that deficit takes the form of “giving money to households” or expanding government spending is a meaningless distinction. The important point is that there is a deficit funded by new money. See:

"that form of fiscal policy is a helicopter drop, a government program that gives money directly to households. The Fed would finance it and the Treasury Department would deliver it to each household."

Could you please tell Scott Sumner this. You guys could start proposing this very sensible idea and Scott could continue to pretend that what he's advocating is monetary policy (because it's the central bank doing it!), when everyone knows it's really money-financed fiscal, duh.

Not with NGDP level targeting. It allows rapid catch up growth (or contraction if needed), but still anchors long-term inflation. As I said in the post, it is nominal anchor. See second half of this post for more details: http://macromarketmusings.blogspot.com/2012/09/john-cochrane-michael-woodford-and.html

I'm confuse if MMonetarists don't believe in liquidity traps and and they claim that monetary policy is highly effective in zero lower bound why you make this case or this is just a emergency unconventional policy?

I use the term liquidity trap loosely here for an economy stuck at the ZLB and in a slump, like we are now.Yes, I believe conventional monetary policy tied to a NGDPLT alone could get us out of such situations, but as the Fed has demonstrated sometimes central banks chose not to act. The helicopter approach can be viewed as insurance against central bank incompetence.

Cut federal taxes by a trillion dollars or two, and monetize all of it through QE and maybe more.

Dudes, the problem is not inflation.

We have an economy much less inflation-prone than in the 1960s, and we were in single-digits then (before deregging transportation, telephones, banking, and with a 91 percent top tax rate, and a unionized workforce and with a Fed that opined that a monetary policy could not fight inflation)

Today, little-boys-in-short-pants half measures do not do the trick. Forget your namby-pamby "helicopter drops" and $85 billion a month in QE.

QE $3-4 trillion and cut taxes by an equal amount.

Send in the B52s, and do not make "drops," make multiple blanket bombing runs.

Jeez, how much more sissy-talk about macroeconomics do we have endure before we get serious about growth?

What do you think the government did from 2009-2013? It massively cut federal taxes (total revenues fell to something like 14-15% of GDP, far below the historical trend), and financed it with massive amounts of QE.

Sure, it wasn't at quite the magnitude you suggest. But it was still quite substantial, and it didn't work. The Fed's mortgage purchases probably had more of an effect.

At some point, we need to admit that transfer payments cannot adequately stimulate demand; the multiplier too low, and spending the necessary amount of money to fill the output gap would panic financial markets. The only fiscal stimulus that works is infrastructure spending, but that requires a counter-cyclical policy of planning and approving infrastructure projects during expansions (it is a time- and red tape- consuming process, after all) then building them during recessions and recoveries.

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About Me

I am an assistant professor of economics at Western Kentucky University in Bowling Green, Kentucky. I am using this blog as an outlet to express my ideas, concerns, and questions on macroeconomics and markets.